Congress Never Intended Windfall for Bond Holdouts

Harald Halbhuber is Counsel at Shearman & Sterling LLP and the author of “Debt Restructurings and the Trust Indenture Act.”

Congressional intent looms large in debt restructurings these days. These restructurings are tools used by companies in financial difficulties and their creditors to effectively reduce the amount of debt and keep operations going. Reorganizing through a Chapter 11 bankruptcy may be an alternative, but comes with additional costs and delays.

Some recent court cases have severely constrained what distressed companies and their creditors can do in debt restructurings to prevent holdout bondholders from free-riding on the sacrifices made by other creditors in staving off bankruptcy. One decision resulted in a small group of unsecured bondholders effectively recovering 100 cents on the dollar, when even secured creditors had to take a haircut. This new line of cases has affected restructurings in all industries and across the country.

The recent cases are based on what is said to have been rediscovered as the intent of Congress when it enacted a bond statute back in 1939. Referred to as the Trust Indenture Act, the statute contains a non-impairment provision protecting every bondholder’s right to receive payment on the bond from being “impaired” without the holder’s consent.

For more than 70 years, this non-impairment provision was rarely litigated. Lawyers read it as simply requiring each bondholder’s consent for changes to payment terms: reducing principal amount or interest rate, pushing out maturity, or converting the bond’s cash claim into equity. Other changes to a bond contract, such as reducing covenant protections, could be made with the consent of holders of a majority of the outstanding bonds, even if they affected the value of those bonds.

What changed? In the recent cases, plaintiffs convinced two judges that the Trust Indenture Act, in a novel interpretation, prohibits not just impairing a bondholder’s legal right to payment, but also transactions that affect their actual recovery on the bond. How did plaintiffs do that, given the long-standing understanding to the contrary? They constructed a story of the Trust Indenture Act as a law that had been on the books for decades, but whose original intent had been largely ignored in debt restructurings. In fact, plaintiffs argued, Congress’ intent in enacting the statute’s non-impairment provision in 1939 had been precisely to permit debt restructurings only in bankruptcy.

Such tales of long-forgotten laws can have intuitive appeal when combined with the right set of facts. In the 2015 restructuring that started this new line of cases, the 10% of unsecured bondholders that were holding out were presented with a particularly stark choice: join the other 90% in the restructuring, or you won’t recover anything on your bonds because our secured lenders will foreclose and transfer all of our assets to a new entity. This may have seemed overly coercive and inequitable to the court, engendering sympathy for the plaintiffs. Dusting off little-used New Deal legislation thus seemed appropriate. It would rein in aggressive present-day Wall Street practices and give Congress’ original intent its due, or so it seemed. But what was that original intent, in fact?

New research being published in a forthcoming law review article of mine sheds light on the purpose of the Trust Indenture Act’s non-impairment provision. The article presents evidence that in the decades leading up to the statute’s enactment, restructurings that presented bondholders with choices not unlike those in the 2015 case were commonplace. The non-impairment provision, it turns out, was not a legislative innovation designed to end those restructurings. It merely copied, more or less word-for-word, long-standing boilerplate that most bond contracts included anyway, and that had coexisted quite happily with those transactions. For the lawyers that drafted the statute and presented it to Congress, “impair” meant changing a bond’s payment terms or making it payable in something other than cash. Those were the changes that Congress wanted to permit only in bankruptcy, by making the boilerplate provision mandatory. The provision was never intended to prohibit other types of restructuring transactions or amendments to bond contracts that did not affect payment terms.

That did not mean that bondholders in those days had no remedies. They could attack restructurings under a variety of legal theories, and they often did. When those bondholders were junior-ranking and thus at risk of losing any recovery on their claims if they did not participate, courts would sometimes step in to ease the pressure. For example, the court might allow bondholders to challenge the restructuring in litigation and still participate in it as latecomers if their challenge was ultimately unsuccessful. That way, they did not risk losing everything by fighting for a better deal. It all depended on the facts of the particular case.

But when courts did intervene, it had nothing to do with the boilerplate non-impairment provision in the bond contract that would later be codified in the Trust Indenture Act. It was simply an exercise of their equitable powers. This was not surprising, because the legal challenges that bondholders brought were often based on concepts of equity. By guarding bondholders’ payment claims against being changed without their consent, the non-impairment provision preserves these equitable protections.

Of course, holdout bondholders today would much prefer relying on the novel interpretation of the Trust Indenture Act. It’s easy, and it’s clean. All they have to show is that there is a debt restructuring to which they did not consent and that, as a result, they will not recover 100 cents on the dollar. In contrast, establishing equitable claims is hard, because it’s asking for something that’s not in the contract, and it’s messy, because it’s fact-specific. Simply saying that you won’t recover the full amount of your claim doesn’t cut it here, and for good reasons.

The first decision in this new line of cases is currently being reviewed by a federal appeals court. It will be interesting to see how the court will evaluate the historical evidence. Concluding that a debt restructuring does not violate the Trust Indenture Act is not tantamount to saying it is legal. Depending on the circumstances, it may not be. But holdout bondholders that believe they are being treated unfairly should make their case just like other creditors, on the basis of the contract or on equitable grounds. There is no evidence that Congress intended windfall recovery for them.

Harald Halbhuber is Counsel in the Capital Markets group at Shearman & Sterling LLP. He is the author of “Debt Restructurings and the Trust Indenture Act,” forthcoming in the next issue of the American Bankruptcy Institute Law Review. This article represents the views of its author, and not those of Shearman & Sterling LLP.